BIS Warns About Destabilizing Low Interest Rates

The financial media is all atwitter (no pun intended) over the Bank of International Settlement’s just released annual report, since it shook a stern finger at central banks for keeping super low interest rates and warned them about the difficulty of renormalizing without kicking up a lot of upheaval.

It’s hardly news that getting out of the corner that the Fed and ECB have painted themselves in won’t be easy, as the taper tantrum of last year demonstrated. The ECB is thus urging central banks to have a hawkish bias, based on the notion that that protracted low rates are destabilizing. That’s highly likely to prove to be true in the long run, as investors continue to reach for return in a low interest rate, low volatility environment. But the BIS implicitly endorses austerity, when it’s austerity that has led to the perverse mechanism of falling back on a protracted period of super low interest rates to keep banks and through the confidence fairy, economies chugging along despite that. We can see how well that is working in the US and Europe. The US “recovery” is running just above stall speed, and Europe’s is a technical recovery.

So while some of the BIS’ warnings are valid, it chooses to ignore that the reason these low interest rates were implemented in the first place was due to poor criss responses, a fact set it omits.

So on the one hand, the BIS correctly warns about the risk of overheating financial markets as a result of super low interest rates. As the Financial Times put it:

While the global economy is struggling to escape the shadow of the crisis of 2007-09, capital markets are “extraordinarily buoyant”, the Basel-based bank said, in part because of the ultra-low monetary policy being pursued around the world. Leading central banks should not fall into the trap of raising rates “too slowly and too late”, the BIS said, calling for policy makers to halt the steady rise in debt burdens around the world and embark on reforms to boost productivity.

In its annual report, the BIS also warned of the risks brewing in emerging markets, setting out early warning indicators of possible banking crises in a number of jurisdictions, including most notably China.

Financial markets have been acutely sensitive to monetary policy, both actual and anticipated. Throughout the year, accommodative monetary conditions kept volatility low and fostered a search for yield. High valuations on equities, narrow credit spreads, low volatility and abundant corporate bond issuance all signalled astrong appetite for risk on the part of investors. At times during the past year, emerging market economies proved vulnerable to shifting global conditions; those economies with stronger fundamentals fared better, but they were not completely insulated from bouts of market turbulence. By mid-2014, investors again exhibited strong risk-taking in their search for yield: most emerging market economies stabilised, global equity markets reached new highs and credit spreads continued tonarrow. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally…

Through its impact on risk-taking behaviour, monetary accommodation had an impact on asset prices and quantities that went beyond its effects on major sovereign bond markets. Credit spreads tightened even in economies mired in recession and for borrowers with non-negligible default risk. Global investors absorbed exceptionally large volumes of newly issued corporate debt, especially that of lower-rated borrowers. And, as the search for yield expanded to equity markets, the link between fundamentals and prices weakened amid historically subdued volatility and low risk premia.

Gee, what about Bernanke/Yellen/Draghi put don’t you understand? Well, actually they do:

Frameworks that fail to get the financial cycle on the radar screen may inadvertently overreact to short-term developments in output and inflation, generating bigger problems down the road. More generally, asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap. Systemic financial crises do not become less frequent or intense, private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent. In this context, economists speak of “time inconsistency”: taken in isolation, policy steps may look compelling but, as a sequence, they lead policymakers astray.

This sort of thing sounds all well and good until you read more carefully: the “fiscal policies run out of ammunition” part. The BIS simply does not grok that you can’t cut deficits without having producing even larger contraction in the economy, worsening debt to GDP ratios. The IMF ‘fessed up to that last year but it appears the BIS did not get the memo.

So the report urges that countries need to put more emphasis on “structural reform” which means balancing budgets and deregulating labor markets even further. Someone needs to send them the video in which venture capitalist Nick Hanauer explains that you can’t kill consumer (how also happen to be laborers) and expect to have a robust economy.

Bill Mitchell explains how the BIS mouths some of the right words but recommends more of the same failed neoliberal medicine:

The BIS tell us that the GFC was a ‘balance sheet recession’. This is true and highlights that it is imperative to understand the nature of any real downturn because when they are linked to financial downturns the consequences for the economy and the correct policy response is different to situations when the real cycle is self-promoting….

The sequence of events that define a balance sheet recession are:

• The private sector builds up massive debt levels to buy property and speculative assets.
• The asset prices rise as demand rises but then eventually the bubble bursts and the private sector is left with declining wealth but huge debt.
• The private sector then start restructuring their balance sheets – and stop borrowing – no matter how low interest rates go.
• All effort is devoted to paying back debt (de-leveraging) and households increase their saving and reduced spending because they become pessimistic about the future.
• A credit crunch emerges – not because there is enough funds but because banks cannot find credit-worthy borrowers to lend to.
• Attempts at pumping liquidity into the banks will fail because they are not reserve-constrained. They are not lending because no-one worthy wants to borrow.
• The faltering spending causes the macroeconomy to melt and output collapses and unemployment rises.
• Balance sheet restructuring for the private sector is a long process of saving and debt retrenchment.
• With this private contraction (reducing debt, saving) the only way out of the balance sheet recession is via public sector deficit spending.

Increased public deficits above the norm are required for an extended period to support income growth that allows the private sector to save and restore the viability of their balance sheets.

The BIS clearly understand that the private debt dynamics are still precarious. But they go into denial when they claim that “More emphasis on repair and reform implies relatively less on expansionary demand management” (p.15)…

The BIS claim that:

After the initial fiscal push, the need to ensure longer-term sustainability has been partly rediscovered. This is welcome: putting the fiscal house in order is paramount; the temptation to stray from this path should be resisted. Whatever limited room for manoeuvre exists should be used, first and foremost, to help repair balance sheets, using public funds as backstops of last resort. A further use, where the need is great, could be to catalyse private sector financing for carefully chosen infrastructure projects … Savings on other budgetary items may be needed to make room for these priorities.

This is the austerity mantra that, in part, led to the crisis in the first place.

I suppose we can’t expect better from a central bank to central banks. So the beatings will continue until morale improves.